Farr: Weak Dollar Can Kill Green Shoots Faster Than Roundup

The US Dollar Index, which averages the exchange rates between the US dollar and six major world currencies, has fallen over 10 percent since the high on March 5, 2009.

The drop in the dollar could reflect a number of different factors, including 1) concerns about the surging US budget deficits and the implications for longer-term inflation; 2) a surge in risk appetite as investors shift focus to emerging economies and away from the US; 3) expectations that a US economic recovery will be slow and drawn out; and 4) efforts by foreign central banks to diversify out of US Treasuries and the US dollar.

Although we suspect each of these factors has played a roll, we also believe that our massive government outlays are the primary cause of the dollar's weakness.

The implications of a weaker dollar are dramatic. They include 1) higher commodity prices, which are generally traded in dollars; 2) higher interest rates as investors in US securities demand higher yields to compensate for currency risk; and 3) higher prices for all other imports. These ancillary effects of a weaker dollar threaten a potential economic recovery and could quickly kill all the "green shoots" that we've been hearing about.

As we have written in past emails, we believe the risks of run-away inflation are low over the near term. Our sentiments on the issue mirror those expressed in a recent Wall Street Journal editorial by David Wessel:

"An immediate outbreak of inflation is improbable. Consumer prices in industrialized countries have risen less in the past year (0.6 percent) than in any 12 months since the Organization for Economic Cooperation and Development began keeping records in 1971. In the U.S., unemployment is at 8.9%, and forecasters see it hovering above 9% into 2011. American industry is operating further from full capacity than at any time since the Fed began keeping track in 1948. It's hard to see companies easily raising prices or workers winning raises. The standard ingredients of inflation -- too much money chasing too few goods -- aren't in evidence."

Unfortunately, however, the market seems to be betting on surge in inflationary pressures in the not-too-distant future, and these bets are putting a potential economic recovery at risk. As the dollar falls, the yield on the 10-year Treasury has risen dramatically to nearly 4% from close to 2 percent at the end of 2008.

The prices of oil and other commodities are also surging. Retail gasoline prices are now averaging over $2.50 per gallon as oil is now trading at over $72 per barrel (up nearly 130 percent from the lows in late December, 2008). A 1 percent rise in mortgage rates equals roughly a 12 percent increase in monthly payment for a 30-year mortgage.

If you believe, as we do, that an apparent stabilization in housing turnover and (to a lesser extent) prices is the direct result of lower mortgage rates, we could be in for more pain. As we've stated many times before, rising mortgage rates and gasoline prices could severely impact consumer confidence and spending going forward, and these factors have displaced credit market dislocation as our primary concern for stocks in the months ahead.

So why is everyone so worried about inflation if there is so much slack in the economy? The answer is that nobody trusts the authorities to make the difficult decisions that lie ahead. From the same Wall Street Journal article:

"The Fed could lack the fortitude to raise rates and drain credit, a worry among some Fed insiders who complain, "There is no exit strategy." The problem is human and political. To avoid inflation, the Fed must move sooner than citizens and politicians will like. Fed Chairman Ben Bernanke vows to be tough, but he hasn't been tested on this side of the monetary mountain -- and his term expires in January 2010. He or his successor may find Fed lending so intertwined with the Treasury's bailouts that the Fed lacks the flexibility and independence it needs. Or he may find tightening tough while Congress is contemplating changes to the Fed's governance and powers. Or the budget deficit may be so large that the Fed is unwilling to curtail its bond buying and raise rates sufficiently to offset it. The Fed is mighty, but its leaders human -- and prone to failures of courage as well as wisdom."

The maintenance of Fed independence is of utmost importance as we work through these difficult times. Perhaps Paul Volcker should be asked to lend his credibility to Mr. Bernanke's Fed. Recall that Volcker was successful in breaking the back of soaring inflation in the early 1980's.

Volcker Foresees 'Long Slog' for U.S. Recovery

Moreover, the federal government MUST signal its willingness to tackle the budget deficits through concrete proposals to lower spending projections. Though voluntary action is very unlikely due to the political implications, it may become absolutely necessary to address entitlement spending now before we damage our credibility and credit-worthiness beyond repair. This is the full body of the post.

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Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.